First of all, I want to emphasize that a lot of normal, hard-working people have lost money because of the crypto market crash in the last week or so. Some people have lost all of their money. While money is not everything, losing a lot of it sure feels like it. If you or someone you know lost money in the LUNA/UST crash, know that life is always worth living.
In case you don't know, terraUSD (UST), a cryptocurrency that is supposed to stay at $1 (aka stablecoin), is no longer $1. When something is supposed to be $1 and it's not, that's usually not good. On top of that, the crypto token that supports UST, LUNA, has also lost virtually all of its value. These losses have already been widely reported, and so this is most likely the zillionth article about UST you've seen.
But it has to be, because readers will recall that I raved about the Luna Foundation Guard (LFG) - the non-profit organization that promotes and stabilizes the Terra ecosystem (which issues UST and LUNA) - when it announced it was buying $10 billion worth of Bitcoin to support UST. To be fair, I was mostly happy to write about something Hal Finney posted on the famous Bitcoin Talk forum. But to be fair ... the truth is that I was not excited about the possibility of a Bitcoin-backed stablecoin.
That said, I'm going to pack as much as I can into this column about Terra without being overwhelming or unoriginal.
Here goes ...
- George Kaloudis
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In the crypto world, there are these things called stablecoins. Stablecoins are usually worth $1. Sometimes they are 1 euro or 1 won, but usually not. The hegemony of the US dollar is to blame. Stablecoins exist so crypto natives can easily get in and out of dollars without needing a bank to approve deposits and withdrawals. Stablecoins facilitate the majority of crypto trading volume and drive the never-ending crypto merry-go-round that is "DeFi" (decentralized finance). More importantly, stablecoins are used by citizens subjected to totalitarian governments that fuel hyperinflation.
There are a few types of stablecoins, most notably Tether (USDT), USD Coin (USDC), Binance USD (BUSD), and Dai (DAI). Also of note was terraUSD (UST). These are the five largest stablecoins, representing about $160 billion in value. Three of these stablecoins (USDT, USDC, BUSD) are collateralized stablecoins issued by centralized entities. These entities hold a treasure trove of dollars that back each coin so that each coin can be redeemed by the holder for $1 with the issuer.
DAIs differ in that they are collateralized and backed by a diversified portfolio of crypto assets. Rather than being issued by a centralized entity, a decentralized autonomous organization (or "DAO") called a MakerDAO manages the DAI. DAIs are collateralized with cryptocurrencies, not dollars, but-and this is critical-they are overcollateralized.
UST is even different. It is not collateralized at all. It is an algorithmic stablecoin based on the Terra protocol. Instead, it is backed by a crypto token called LUNA. I described how this works in a previous newsletter:
When the UST price is too high (>$1), the protocol incentivizes users to burn (destroy) LUNA and mint (manufacture) UST. If the UST price is too low (<$1), the protocol incentivizes users to burn (destroy) UST and mint (manufacture) LUNA.On the surface, this is pretty clever. It's simple. When the demand for UST is high enough to raise the price to $1.01, the protocol prints some UST in exchange for some LUNA. The problem is that it works perfectly until it stops working. And last Monday it stopped working ...
It should be $1, not 11 cents. The LUNA chart looks worse somehow.
OK, of course you think the mechanism is broken or something. It's not broken. It worked as intended, and you can see that by looking at the amount of LUNA that was issued when the protocol tried to algorithmically bring UST back to $1, while the LUNA price crashed as well.
That's right. The total supply of LUNA went from about 725 million tokens on May 5 to about 7 trillion on May 13. Meanwhile, LUNA lost 99.9% of its value. This is what hyperinflation looks like.
As mentioned earlier, Terraform Labs (the company behind Terra) put forward a plan to buy $10 billion worth of Bitcoin and other crypto assets through LFG to serve as a backstop in case something like this happened. The problem remained, however. UST was not fully collateralized like the other stablecoins in the top 5. Before the collapse, UST's market cap was $18 billion, far more than the nearly $4 billion the Foundation had in reserve.
Whatever happened, we got lucky
Our friends at crypto data provider Kaiko have done a great job breaking down exactly what happened. The short version is as follows: UST fell below $1, and all attempts, both by the Terra Protocol algorithm and by lending LFG reserves to trading companies, failed to get UST back to $1. Between UST and LUNA, over $40 billion in value was lost.
What exactly happened doesn't really matter. What matters is that Terra was not able to deal with the disaster when it happened. What really matters is that an under-collateralized algorithmic stablecoin will fail no matter how long it succeeds.
The system did fail. But if we are honest, UST was a huge success until the moment it stopped working. History should serve as a lesson for us here when we see a successful UST copycat emerge in 2027 or however.
We are also incredibly lucky that UST and LUNA are not so large or so intertwined as to cause mass hysteria in all markets. I really think we were lucky that this happened in 2022 and not 2030. Matt Levine of Bloomberg put it well:
"If in five years all cryptocurrencies go to zero ... well, I don't know what the next five years will look like, but one plausible story (as of last week, anyway!) is that the integration of cryptocurrencies into the real economy will continue. More and more crypto companies will be big and important and intertwined with other companies; their stocks will be in indexes, and they will borrow money from banks and use their own money to fund real businesses. ... Crypto platforms will be used for real economic activities; ordinary people will invest their savings in these platforms, and these investments will be used to finance real, non-crypto business activities.Exactly right. Even if you're a bitcoin maximalist like me, praying for the day we return to just one cryptocurrency, you have to admit that we'll see more cryptocurrencies in more industries in the short to medium term. Except that the next time an under-collateralized algorithmic stablecoin fails, the loss in value won't be $40 billion. It could be $400 billion. That could be catastrophic. We should avoid that scenario at all costs.
What else did we learn from the UST crash?
ThePositivething is that Bitcoin did not completely collapse. More than 80,000 BTC from the nearly $4 billion hoard may have been sold (we can't confirm yet if the Bitcoins were actually sold, but they were sent to exchanges) during the mad dash to bring UST back to $1. That caused a price reaction, sure, but then again the broader crypto market sold off because something bad happened to a major crypto project (LUNA was once the 10th most valuable cryptocurrency). Add to that the uncertain macroeconomic environment and the general risk appetite in the market, and it seems almost impossible that Bitcoin still has a market cap of over $500 billion.
I think we are numb to these big numbers given the unprecedented bull market of the last 13 years, and so this bears repeating. Bitcoin was a worthless, pure peer-to-peer version of electronic money created by an unknown person in 2009. No major company or government invested marketing, research, or legal money in Bitcoin, and yet it is now a serious macro asset that major politicians and financiers need to speak out about.
A serious macro asset that can withstand huge amounts of selling and still ... not ... disappear. Bitcoin is here to stay. So are cryptocurrencies. As long as we learn from it, that can be a good thing.
But if history is any indication, we still need to make sure that overconfidence doesn't make the best of "us" in the future.